Weekly Update: I can't predict the future

06-02-2017

For the past 2½ years, I have been hearing economists talk about how annual wage growth will jump to 4% in the next 6 months, the Fed’s tightening pace will quicken and the expansion will enter the late stages and ultimately recession. I can’t predict the future and would never pretend to, although many market pundits do. But I do know that throughout all this time, wage growth has remained stuck around 2-2.5%, 10-year Treasury yields have been stuck in the 2-2.5% range, and core inflation has yet to hit and stick at the Fed’s 2% target. This morning’s jobs report was more of the same (more below). Watching the TV in my New York hotel room before a series of media interviews, all I heard was how disappointing the report was, how the nonfarm jobs number came in below even the worst Wall Street forecast. And I thought, is this really bad news? It fits with what I’ve been saying in all my meetings for years—we’re in a long grind of slow growth, low inflation and sluggish wage growth. Continued growth with subdued inflation. Goldilocks for the markets. The major indexes keep hitting new highs, and as I was leaving my room at 9 a.m. for my first interview, all the stock index futures were flashing green.

With the forward P/E multiple for the S&P 500 at 17.65, the economy will have to accelerate for more than one quarter for the rally to extend its life. And we are seeing signs of that (more below). Earlier in the week, I talked to a reporter from the AP who also noted that the drumbeat is loud and louder about only handful of stocks driving the market. Much is being discussed and written about this, as May was a very narrow market, with Tech up 3.4%, Utilities up 2.2% and every other sector down. The S&P undoubtedly is a large-cap index, which is where the gains of late have been made, led overwhelmingly by what Ned Davis calls the “sexy six:” Microsoft, Apple, Facebook, Amazon, Netflix and Google, aka Alphabet. But with an accommodative Fed in the absence of troublesome inflation (core PCE is at its lowest point since December 2015) and growth continuing to be steady if unspectacular (whether the agreed-upon strong Q2 will carry into 2018 is under debate), should we be surprised the market keeps carrying on? This is a Goldilocks environment for stocks. When the AP reporter asked me what I thought about the market hitting a new record high (which was the case at the time), I said the market probably has gotten ahead of itself—we probably shouldn’t annualize the year-to-date returns. But I am not surprised. There are many, many, many advisors out there with dry powder waiting for the elusive pullback. Ned Davis reports if we don’t see a 5% decline in the MSCI ACWI Index over the next year, the current run would be far and away the longest without a correction of meaningful magnitude.

The market also cares much more about policy than politics. And despite all the noise, Washington continues to push ahead with a pro-growth agenda of regulatory relief, tax reform and infrastructure spending. The timing may be uncertain given all the D.C. drama, but corporate America can wait. FBN Securities observes no corporate executive has argued they need help from Washington to meet their high bar for consensus profit growth. Moreover, everywhere I travel, I continue to hear from advisors that they have vital cash waiting to be invested. With the pain trade remaining to the upside, it’s not surprising when they throw in the towel, helping to further fuel the market advance. A good example came almost three weeks ago, when Trump fired FBI Director James Comey and the “i” word (i.e., impeachment) gave us a 1-day, 1.8% pullback. On the road at the time, I thought a correction would make a good buying opportunity. But I am not brilliant. Everyone else was thinking the same thing. So the “correction” lasted one day. The reporter wanted to talk politics. Did I think Trump’s announcement that the U.S. is pulling out of the Paris Climate Accord marks the beginning of a U.S. isolationist pattern and policies that would commence in a trade war, with negative implications for economic growth? To which I responded, that’s a serious jump to get from A to B, and I’m not going there. You see, I can’t predict the future.

Positives

Consumers plod along Although the Conference Board’s consumer confidence fell more than expected in May, it remained buoyant and close to post recession highs. Consumer spending also rose in April, getting the second quarter off on a strong note. However, the pace of spending remains more subdued than robust, with May auto sales slipping after April’s increase.

Economy plods alongThe latest Beige Book found activity expanding at a modest-to-moderate pace across most districts in early April through late May, while the Philly Fed State Leading Indexes projected growth to increase in 46 states over the summer. There was some deterioration in breadth—the net share of expanding states fell to 92%, matching its second-lowest level in this expansion. But the overall leading index suggested a modest pickup in real GDP growth over the next 6 months.

A rosier take on manufacturing Last week’s weakness in the preliminary Markit and Richmond Fed readings were overwhelmed this week by favorable regional readings in Chicago and Texas, as well as upbeat final Markit and national ISM reports. The Chicago barometer hit a 2½-year high, factory production in Texas reached a 3-year high, the final Markit index was revised up and May’s manufacturing ISM rose in line with expectations as production and new orders remained robust.

Negatives

Labor market tightens The unexpectedly weak nonfarm payroll job gains after the strong ADP report may reflect a growing issue confronting employers: increasing difficulty finding qualified workers. Online help-wanted ads rose in May by the most since December 2012, and the labor demand/supply ratio suggests further tightness. Demographics are a key reason. The 10-year annualized growth rate of the working-age population is its lowest level since the start of the series in the late 1950s. More significantly, the 16-to-64 working-age population grew just 0.5% annually over the past 10 years—the lowest on record. The rising growth rate of younger workers and declining growth rates of older workers explain why productivity growth is weak, and along with evaporating global barriers for jobs and AI taking jobs, are keeping wage inflation subdued.

Housing market tightens Pending home sales in April fell for the third time in the past 4 months, with sales contracts on a year-over-year basis off the most since June 2014. The National Association of Realtors attributes this weakness to deteriorating affordability conditions, as inadequate supply continues to push existing home prices higher. Its outlook is for these trends to continue for the rest of this year, with existing home sales rising 3.5% this year and the median existing home price rising 5%.

Construction spending disappointssomewhat April unexpectedly fell, led by a big drop in public construction spending. On the private side, the decline was modest, with softness in both residential and non-residential categories. Much of the decline in private residential construction was in home improvements as single- and multi-family private construction spending continued to maintain good momentum, a positive for residential investment this quarter. Further, the upward revisions to March data imply better momentum in construction spending in Q2.

What else

This is what happens when debt is so cheap According to the IMF’s financial stability report, the median net debt-to-EBITDA of the S&P is near an all-time high, with the growth of leverage broad-based across industries and company sizes. A review beyond the S&P to nearly 4,000 firms that account for about half of the economy-wide corporate-sector balance sheet suggests a similar rise in leverage “to levels exceeding those prevailing just before the global financial crisis.” Hmm.

Political Watch Historically, when an administration gets in trouble, it doubles down on policy. Congressional Republicans now see an expiration date on their control on Congress and this is forcing them to get their act together or risk coming to midterms with little to show save controversies. Thus, Strategas Research says investors should not be caught off guard in coming weeks when Trump releases a large infrastructure package and the Senate coalesces around a tax reform plan.

Our fading car culture A new report predicts that we’re on the edge of an incredibly rapid transition to an entirely new transportation system–where it will be so much cheaper and easier to not own a car, you’ll get rid of yours as soon as you can. By 2030, 95% of passenger miles traveled in the U.S. could be happening in on-demand, autonomous electric cars owned by fleets rather than individuals.

Recent Equity

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

MSCI All Country World Index (MSCI ACWI): A free float-adjusted, market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of November 2011, the MSCI ACWI consisted of 45 country indices comprising 24 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and United States. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey. The index is unmanaged, and it is not possible to invest directly in an index.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

The Chicago Purchasing Managers Index, produced by the Institute of Supply Management-Chicago, gauges factory and services health in the upper Midwest based on surveys of companies in that region.

The Conference Board's Consumer Confidence Index measures how optimistic or pessimistic consumers are about the economy.

The Federal Reserve Bank of Dallas' monthly Texas Manufacturing Outlook Survey is a measure of the current level of activity and expectations for the future.

The Federal Reserve Bank of Philadelphia produces a monthly leading index that gauges economic activity in all 50 states.

The Federal Reserve Bank of Richmond Monthly Manufacturing Survey survey is a gauge of activity and expectations for the future among manufacturers in its district.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking derived from a monthly survey of U.S. businesses.